Why We Sold Kraft Heinz Co. (KHC)

July 7, 2017

On Friday, July 7, we sold Kraft Heinz Co. (KHC). Kraft Heinz is a long-term holding in AMM Dividend Strategy portfolios. We first received shares when the original Kraft split into 2 companies, Mondelez (MDLZ) and Kraft Foods (KRFT). Then Heinz Co., privately held and run by 3G Capital, partnered up with Warren Buffett and Berkshire Hathaway to buy Kraft Foods. They renamed the company Kraft Heinz Co. (KHC).

When Heinz bought Kraft Foods it followed the standard 3G Capital acquisition model. Buy a large company with bloated costs and operational inefficiency. Then implement zero-based budgeting to drastically reduce costs, improve margins, increase returns on equity and capital. Use increased cash flow to reduce the debt used to finance the transaction. Then repeat every 2-3 years.

Buy, Cut Costs, Repeat?

It is time for Kraft Heinz to buy another company and repeat the formula. The problem, and one of the reasons we sold KHC, is finding an acquisition target is harder. Other consumer food companies do not want to be bought out by Kraft Heinz. Potential targets have already implemented zero-based budgeting. The stock prices of prime acquisition targets have also increased because of the expectation that Kraft Heinz may buy them. The higher the price Kraft Heinz has to pay the lower potential return they can get out of the merger.

Kraft Heinz’ announcement earlier this year to buy Unilever (UL) highlights the limited pool of acquisition targets. Unilever’s largest business division is consumer care with brands like Axe Body Wash and Dove Soap. The Consumer Care and Food divisions represent 38% and 24% of Unilever’s revenue respectively. Kraft Heinz is focused solely on food. Additionally, Unilever’s food product portfolio has limited overlap with Kraft Heinz’s. The limited overlap and large portfolio of consumer care products likely limits the amount of synergies and cost reductions Kraft Heinz could achieve by merging the two product portfolios.

Trading at a Premium

Given 3G’s past success, expectations are high for Kraft Heinz to do another successful deal. High expectations lead to excessive valuations. Kraft Heinz currently trades at high multiples relative to its peers and the market as a whole.

KHC vs Peers EV/EBITDA

KHC vs Peers P/FCF

Kraft Heinz also trades at a premium to our estimate of intrinsic value and it has for a while. This is why we haven’t added it recently to portfolios or new accounts.

Secular Shifts

The final reason we sold is the secular shift in food. Kraft Heinz dominates the center aisle of the grocery store. Consumers are increasing their purchasing around the periphery: Fresh fruits and vegetables, Fresh meat, pre-made in-store meals.

The big food sellers like Kraft Heinz have lost market share to smaller food companies and the shift towards “better for you” food. From The Wall Street Journal.

The 25 largest food and beverage companies commanded a 63% share of $495 billion in U.S food and beverage sales in 2016, according to consultancy A.T. Kearney.

That is down from 66% in 2012, and even seemingly small market-share losses hurt sales and profits.

The other big shift in food purchasing habits is the move to cheaper white label products. Do you buy Kraft’s Macaroni and Cheese Dinner or do you buy the store brand box that will taste more or less the same for less money? Consumers are opting for the white label brand, “Private-label-product shelf space has expanded 3.5% a year since 2012”.

Given these factors, we sold Kraft Heinz in all dividend strategy accounts that held shares. We could have continued to hold Kraft Heinz, collect the dividend and then sell if or when they make another acquisition announcement. However, there remains a risk that the acquisition announcement takes longer than we thought or doesn’t happen at all. Instead, we decided to harvest our gains now. We are not putting the cash to work right away. There are several companies that we would like to buy with much better long-term revenue and dividend growth prospects. We are just waiting for the right price.